1. 4 4 The Firm’s Production and Selling Decisions

2. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. ●Production and Input Choice, with One Variable Input ●Multiple Input Decisions: The Choice of Optimal Input Combinations ●Cost and Its Dependence on Output ●Economies of Scale ●Production and Input Choice, with One Variable Input ●Multiple Input Decisions: The Choice of Optimal Input Combinations ●Cost and Its Dependence on Output ●Economies of Scale Outline

3. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. ●Price and Quantity: One Decision, Not Two ●Total Profit: Keep your Eye on the Goal ●Marginal Analysis and Maximization of Total Profit ●Generalization: The Logic of Marginal Analysis and Maximization ●Price and Quantity: One Decision, Not Two ●Total Profit: Keep your Eye on the Goal ●Marginal Analysis and Maximization of Total Profit ●Generalization: The Logic of Marginal Analysis and Maximization Outline

4. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Production and Input Choice, with 1 Variable Input ●Arkansas chicken farmer named Florence, who owns a small poultry business. ♦She knows Q corn she feeds her chickens will impact Q meat. ♦She could also buy more T, growth hormones, and L to ↑Q meat. But for now, let’s focus on the relationship between poultry meat and corn. ●Arkansas chicken farmer named Florence, who owns a small poultry business. ♦She knows Q corn she feeds her chickens will impact Q meat. ♦She could also buy more T, growth hormones, and L to ↑Q meat. But for now, let’s focus on the relationship between poultry meat and corn.

5. TABLE 1. TPP, MPP, and APP for Flo’s Chicken Farm Corn in bagsTPP in lbs.MPP in lbs.APP in lbs. 00.0----- 114.0 236.022.018.0 366.030.022.0 4100.034.025.0 5130.030.026.0 6156.026.0 7175.019.025.0 8184.09.023.0 9185.41.420.6 10180.0-5.418.0 11165.0-15.015.0 12144.0-21.012.0

6. FIGURE 1. TPP with Different Quantities of Corn

7. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Production and Input Choice, with 1 Variable Input ●Total Physical Product (TPP) = amount of output that can be produced as 1 input changes, with all other inputs held constant. ♦Table 1 shows TPP or how much chicken Flo can produce with different Q corn, holding all other inputs fixed. ♦If Q corn = 0 → Q meat = 0. Each add. bag of corn yields more poultry. 4 bags → 100 lbs. After 9 bags, ↑corn → ↓output –chickens are so overfed they become ill. ●Total Physical Product (TPP) = amount of output that can be produced as 1 input changes, with all other inputs held constant. ♦Table 1 shows TPP or how much chicken Flo can produce with different Q corn, holding all other inputs fixed. ♦If Q corn = 0 → Q meat = 0. Each add. bag of corn yields more poultry. 4 bags → 100 lbs. After 9 bags, ↑corn → ↓output –chickens are so overfed they become ill.

8. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Production and Input Choice, with 1 Variable Input ●Average Physical Product (APP) = TPP/(Q of input) = measures output per unit of input. ♦E.g., 4 bags corn → 100 lbs meat, so APP = 25. ●Marginal Physical Product (MPP) = additional output resulting from a 1 unit increase in the input, holding all other inputs constant. ♦E.g., ↑corn from 4 to 5 bags, the 5th bag yields an add. 30 lbs of meat. ●Average Physical Product (APP) = TPP/(Q of input) = measures output per unit of input. ♦E.g., 4 bags corn → 100 lbs meat, so APP = 25. ●Marginal Physical Product (MPP) = additional output resulting from a 1 unit increase in the input, holding all other inputs constant. ♦E.g., ↑corn from 4 to 5 bags, the 5th bag yields an add. 30 lbs of meat.

9. FIGURE 2. Flo’s MPP Curve

10. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Graph of MPP ●Marginal returns to an input typically rise and then fall. ●Area of ↑MPP (1 to 4 bags) → each add. bag of corn adds more to TPP than previous bag. ↑TPP rapidly. ●Area of ↓MPP (between 4 and 9 bags) → each add. bag of corn adds less to TPP than previous bag. ↑TPP at a dim. rate. ●Area of (-)MPP (beyond 9 bags) → each add. bag of corn reduces TPP by more than previous bag. ↓TPP. ●Marginal returns to an input typically rise and then fall. ●Area of ↑MPP (1 to 4 bags) → each add. bag of corn adds more to TPP than previous bag. ↑TPP rapidly. ●Area of ↓MPP (between 4 and 9 bags) → each add. bag of corn adds less to TPP than previous bag. ↑TPP at a dim. rate. ●Area of (-)MPP (beyond 9 bags) → each add. bag of corn reduces TPP by more than previous bag. ↓TPP.

11. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. ●↑ Q of any one input, holding Q of all other inputs constant, leads to lower marginal returns to the expanding input. ♦E.g., Flo feeds chickens more and more, without giving them extra water, cleaning up after them more, or buying add. chickens. Eventually overfed and become sick. ●Law of dim. marginal returns should hold for most activities. Can you think of one? ●↑ Q of any one input, holding Q of all other inputs constant, leads to lower marginal returns to the expanding input. ♦E.g., Flo feeds chickens more and more, without giving them extra water, cleaning up after them more, or buying add. chickens. Eventually overfed and become sick. ●Law of dim. marginal returns should hold for most activities. Can you think of one? The “Law” of Diminishing Marginal Returns

12. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Optimal Purchase Rule for a Single Input ●How does a firm decide on the quantity of an input? ♦Assume P corn = $10/40-lb bag and P chicken = $0.75/lb. Consider purchasing just 1 bag of corn. Does this max profits? ●1 bag produces 14 lbs of chicken. TR: $0.75 x 14 = $10.50 TC: $10 x 1 = $10.00 Profit: = $0.50 ●Shouldn't stop at 1 bag because 2 bags yield more profit. TR: $0.75 x 36 = $27.00 TC: $10 x 2 = $20.00 Profit: = $7.00 ●How does a firm decide on the quantity of an input? ♦Assume P corn = $10/40-lb bag and P chicken = $0.75/lb. Consider purchasing just 1 bag of corn. Does this max profits? ●1 bag produces 14 lbs of chicken. TR: $0.75 x 14 = $10.50 TC: $10 x 1 = $10.00 Profit: = $0.50 ●Shouldn't stop at 1 bag because 2 bags yield more profit. TR: $0.75 x 36 = $27.00 TC: $10 x 2 = $20.00 Profit: = $7.00

13. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Optimal Purchase Rule for a Single Input ●Easier way to proceed. Until 9 bags, each add. bag of corn ↑Q chicken. So each bag (1-9) raises TR, but also costs $10. To max profit, Flo should compare revenue that each bag generates against the cost of each bag. ●Marginal Revenue Product (MRP) = MPP x Price of output. ●MRP = add. revenue generated from ↑input by 1 unit. ●Easier way to proceed. Until 9 bags, each add. bag of corn ↑Q chicken. So each bag (1-9) raises TR, but also costs $10. To max profit, Flo should compare revenue that each bag generates against the cost of each bag. ●Marginal Revenue Product (MRP) = MPP x Price of output. ●MRP = add. revenue generated from ↑input by 1 unit.

14. Bags of Corn TPPMPPTR (P*TPP) MRP (P*MPP) P cornProfit 00.0-----$0.00-----$10.00$0.00 114.0 10.50$10.5010.000.50 236.022.027.0016.5010.007.00 366.030.049.5022.5010.0019.50 4100.034.075.0025.5010.0035.00 5130.030.097.5022.5010.0047.50 6156.026.0117.0019.5010.0057.00 7175.019.0131.2514.2510.0061.25 8184.09.0138.006.7510.0058.00 9185.41.4139.051.0510.0049.05 10180.0-5.4135.00-4.0510.0035.00 11165.0-15.0123.75-11.2510.0013.75 12144.0-21.0108.00-15.7510.00-12.00 Table 2. Flo’s TPP, MPP, and MRP Schedules

15. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Optimal Purchase Rule for a Single Input ●Rule: If MRP > P of an input → use more of the input. If MRP < P of an input → use less of the input. ●Purchase an input where MRP = P of the input. ♦E.g., Flo should purchase 7 bags of corn. Can you explain why she should not buy the 8th bag? ●Note: ↓MPP (bag 4 to 9) → ↓MRP. At 7 bags, Flo is producing where dim. MPP sets in. Flo should stop ↑corn purchases when MRP falls to = P of corn. ●Rule: If MRP > P of an input → use more of the input. If MRP < P of an input → use less of the input. ●Purchase an input where MRP = P of the input. ♦E.g., Flo should purchase 7 bags of corn. Can you explain why she should not buy the 8th bag? ●Note: ↓MPP (bag 4 to 9) → ↓MRP. At 7 bags, Flo is producing where dim. MPP sets in. Flo should stop ↑corn purchases when MRP falls to = P of corn.

16. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Multiple Input Decisions ●Firms seek the method of production that is least costly. ♦Consider the choice between L and K in prod. Compared with Mexico, in U.S., L is expensive and K is cheap. So (K/L) U.S. > (K/L) Mexico ●One input can often be substituted for another in production. ♦E.g., shoes produced in Mexico are manufactured using more L and less K than shoes in U.S. ●Firms seek the method of production that is least costly. ♦Consider the choice between L and K in prod. Compared with Mexico, in U.S., L is expensive and K is cheap. So (K/L) U.S. > (K/L) Mexico ●One input can often be substituted for another in production. ♦E.g., shoes produced in Mexico are manufactured using more L and less K than shoes in U.S.

17. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Multiple Input Decisions ●A firm can produce same amount of a good with less of one input (say L) as long as it’s willing to use more of another input (like K). ●Actual combos of inputs (such as K and L) depend on relative P of inputs. Firms strive to produce a good using the least expensive method. ●A firm can produce same amount of a good with less of one input (say L) as long as it’s willing to use more of another input (like K). ●Actual combos of inputs (such as K and L) depend on relative P of inputs. Firms strive to produce a good using the least expensive method.

18. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Marginal Rule for Optimal Input Proportions ●E.g., Flo can feed chickens soymeal or cornmeal –they are substitutes in production. ♦Not perfect substitutes. Soymeal has more protein but fewer carbohydrates than corn. ♦Best to feed some combo of 2 meals. ↓Q poultry if Flo relies too much on 1 input. There are dim. returns to substitution among the inputs. ●E.g., Flo can feed chickens soymeal or cornmeal –they are substitutes in production. ♦Not perfect substitutes. Soymeal has more protein but fewer carbohydrates than corn. ♦Best to feed some combo of 2 meals. ↓Q poultry if Flo relies too much on 1 input. There are dim. returns to substitution among the inputs.

19. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Marginal Rule for Optimal Input Proportions How much of each input should Flo purchase? ●Feed ↑corn and ↓soy. Soy costs twice as much, but yields only 67% more meat. ●If Flo ↓soy by 1 bag → saves $20. But ↓output by 50 lbs. So buy 1.67 (or 50/30) bags of corn to make up for ↓output, cost = $16.70. She saves $3.30 while holding Q output fixed. Price corn = $10 per 40 lb. bagMPP bag corn = 30 lbs. meat Price soy = $20 per 40 lb. bagMPP bag soy = 50 lbs. meat

20. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Marginal Rule for Optimal Input Proportions ●Above: MPP soy /P soy < MPP corn /P corn i.e., 50/$20 < 30/$10 ♦Soy yields 2.5 lbs. meat per $1 while corn yields 3 lbs. per $1. More output from corn rather than soy at the margin. ●MPP of an input/P of an input = add. output from spending $1 on the input. ●By substituting input with lower output per $1 for input with higher output per $1; firm can reduce costs while holding Q output fixed. ●Above: MPP soy /P soy < MPP corn /P corn i.e., 50/$20 < 30/$10 ♦Soy yields 2.5 lbs. meat per $1 while corn yields 3 lbs. per $1. More output from corn rather than soy at the margin. ●MPP of an input/P of an input = add. output from spending $1 on the input. ●By substituting input with lower output per $1 for input with higher output per $1; firm can reduce costs while holding Q output fixed.

21. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Marginal Rule for Optimal Input Proportions ●Rule: if MPP b /P b > MPP a /P a → spend less on input a and more on input b. ♦Optimally, MPP a /P a = MPP b /P b ●Above: MPP corn /P corn > MPP soy /P soy ♦These ratios will equalize at an optimum because of dim. MPP. As Flo uses ↑corn and ↓soy → ↓MPP corn and ↑MPP soy, until two ratios are equal. ●Rule: if MPP b /P b > MPP a /P a → spend less on input a and more on input b. ♦Optimally, MPP a /P a = MPP b /P b ●Above: MPP corn /P corn > MPP soy /P soy ♦These ratios will equalize at an optimum because of dim. MPP. As Flo uses ↑corn and ↓soy → ↓MPP corn and ↑MPP soy, until two ratios are equal.

22. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Marginal Rule for Optimal Input Proportions ●Changes in Input Prices and Input Proportions: ●Optimally, MPP corn /P corn = MPP soy /P soy ●What if ↑P corn? ♦Then ↑MPP corn to match ↑P corn. How? Flo will use ↓corn and ↑soy until ratios are equal. ●As ↑P input → firms switch to cheaper inputs. ●Changes in Input Prices and Input Proportions: ●Optimally, MPP corn /P corn = MPP soy /P soy ●What if ↑P corn? ♦Then ↑MPP corn to match ↑P corn. How? Flo will use ↓corn and ↑soy until ratios are equal. ●As ↑P input → firms switch to cheaper inputs.

23. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. ●3 different cost curves –Total Cost (TC), Average Cost (AC), and Marginal Cost (MC). ●Flo’s costs depend on Q of inputs and on P of those inputs. ●To calculate costs, assume: ♦ P corn is beyond Flo's control. ♦Q of all other inputs (except corn) are fixed. ♦P corn = $10 per 40 lb. bag ●3 different cost curves –Total Cost (TC), Average Cost (AC), and Marginal Cost (MC). ●Flo’s costs depend on Q of inputs and on P of those inputs. ●To calculate costs, assume: ♦ P corn is beyond Flo's control. ♦Q of all other inputs (except corn) are fixed. ♦P corn = $10 per 40 lb. bag Cost Curves and Input Quantities

24. TABLE 3. TPP, TC, and AC for Flo’s Chicken Farm TPP of chicken (lbs. per week) Corn input (bags per week) Total Cost (per week) Average Cost (TC/Q output) 0000.00 141100.71 362200.56 663300.45 1004400.40 1305500.38 1566600.38 1757700.40 1848800.43 185.49900.49

25. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Cost Curves and Input Quantities ●TPP → Q output firm can produce given Q inputs. Q inputs and P inputs → firm can determine TC of producing any Q output. ●TC = P inputs x Q inputs ●AC = TC/Q output ♦E.g., TC 100 lbs = $40 → AC = $40/100 = $0.40 ●MC =  TC when output increases by 1 unit ♦E.g., if TC 100 lbs. = $40.00 TC 99 lbs. = $39.70 MC 100 th lb. = $0.30 ♦Note: table above doesn’t show this because ↑output > 1. ●TPP → Q output firm can produce given Q inputs. Q inputs and P inputs → firm can determine TC of producing any Q output. ●TC = P inputs x Q inputs ●AC = TC/Q output ♦E.g., TC 100 lbs = $40 → AC = $40/100 = $0.40 ●MC =  TC when output increases by 1 unit ♦E.g., if TC 100 lbs. = $40.00 TC 99 lbs. = $39.70 MC 100 th lb. = $0.30 ♦Note: table above doesn’t show this because ↑output > 1.

26. FIGURE 3. Flo’s Total Cost Curve

27. FIGURE 4. Flo’s Average Cost and Marginal Cost Curves AC and MC typically ↓ and then ↑ as the ↑output level.

28. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. ●TC, AC, and MC can be divided into 2 parts –fixed costs and variable costs. ●Fixed cost is the cost of an input whose Q does not ↑ when ↑output. Input that the firm requires to produce any output. Any other cost is a variable cost. ♦E.g., takes at least 1 taxi to run a cab co. and its cost is the same whether 1 or 60 people ride in it. But gas use rises as more people ride. Taxi is a fixed cost and gas is a variable cost. What are the fixed and variable costs where you work? ●TC, AC, and MC can be divided into 2 parts –fixed costs and variable costs. ●Fixed cost is the cost of an input whose Q does not ↑ when ↑output. Input that the firm requires to produce any output. Any other cost is a variable cost. ♦E.g., takes at least 1 taxi to run a cab co. and its cost is the same whether 1 or 60 people ride in it. But gas use rises as more people ride. Taxi is a fixed cost and gas is a variable cost. What are the fixed and variable costs where you work? Fixed and Variable Costs

29. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. ●TC = TVC + TFC ●AC = AVC + AFC ♦AC = TC/Q output ♦AVC = TVC/Q output ♦AFC = TFC/Q output ●TC = TVC + TFC ●AC = AVC + AFC ♦AC = TC/Q output ♦AVC = TVC/Q output ♦AFC = TFC/Q output Fixed and Variable Costs

30. Table 4. Flo’s Total and Average Fixed Costs Output (20 lb pack) TFC $ / week AFC $ / week 0 5.0--- 15.0 5.00 25.02.50 35.01.70 45.01.25 55.01.00 65.00.80 75.00.70 85.00.60 Flo pays rent of $5 per week for her chicken coop.

31. FIGURE 5. Graph of Flo’s Total Fixed Cost

32. FIGURE 6. Graph of Flo’s Average Fixed Cost If Flo produces 1 package, TFC is carried by 1. But if she produces 4, TFC gets divided between 4 packages. So ↓AFC as ↑output.

33. FIGURE 7. Flo’s Total Variable Cost Curve TVC has same shape as TC because ↑variable costs as ↑output.

34. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. ●Marginal Cost = Marginal Variable Cost (MVC) Why doesn't MC have a fixed component (i.e., MC = MVC + MFC)? ●Marginal Cost = Marginal Variable Cost (MVC) Why doesn't MC have a fixed component (i.e., MC = MVC + MFC)? Fixed and Variable Costs

35. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. ●AC is generally U shaped –it initially declines and eventually rises with the level of output. ●AC declines for 2 reasons: 1.Changing input proportions: at first, Flo feeds chickens more corn while holding all other inputs constant. Output rises rapidly when ↑MPP corn, which tends to ↓AC. 2.↓Average fixed costs as ↑output. ●AC is generally U shaped –it initially declines and eventually rises with the level of output. ●AC declines for 2 reasons: 1.Changing input proportions: at first, Flo feeds chickens more corn while holding all other inputs constant. Output rises rapidly when ↑MPP corn, which tends to ↓AC. 2.↓Average fixed costs as ↑output. Shape of the Average Cost Curve

36. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. ●AC eventually rises for 2 reasons: 1.Dim MPP: ↑output more slowly as ↓MPP corn, which tends to ↑AC. 2.Bureaucratic mess: as firms grow in size they lose personal touch of management and become increasingly bureaucratic, which drives up costs. ●Point where ↑AC varies by industry. AC in auto industry begins ↑ after more units of output than farming. Huge K investment → AFC↓ dramatically. ●AC eventually rises for 2 reasons: 1.Dim MPP: ↑output more slowly as ↓MPP corn, which tends to ↑AC. 2.Bureaucratic mess: as firms grow in size they lose personal touch of management and become increasingly bureaucratic, which drives up costs. ●Point where ↑AC varies by industry. AC in auto industry begins ↑ after more units of output than farming. Huge K investment → AFC↓ dramatically. Shape of the Average Cost Curve

37. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Short-run versus Long-run Costs ●Cost of changing a firm's output level depends on period of time under consideration. Many input choices are precommitted by past decisions. ●Sunk cost = a cost to which a firm is precommitted for some limited period of time. ♦E.g., a 2-year-old machine with a 9-year economic life is a variable cost after 7 years because the machine would have to be replaced anyway. ●Cost of changing a firm's output level depends on period of time under consideration. Many input choices are precommitted by past decisions. ●Sunk cost = a cost to which a firm is precommitted for some limited period of time. ♦E.g., a 2-year-old machine with a 9-year economic life is a variable cost after 7 years because the machine would have to be replaced anyway.

38. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Short-run versus Long-run Costs ●SR = period of time when some of the firm's cost commitments end. ●LR = period of time when all of the firm's cost commitments end. ●There are no fixed costs in LR –all costs are variable. ♦E.g., if # of workers can be altered daily, and # of machines altered yearly, and size of plant every 10 years. Then 10 years is the LR. ●SR = period of time when some of the firm's cost commitments end. ●LR = period of time when all of the firm's cost commitments end. ●There are no fixed costs in LR –all costs are variable. ♦E.g., if # of workers can be altered daily, and # of machines altered yearly, and size of plant every 10 years. Then 10 years is the LR.

39. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Short-run versus Long-run Costs ●Size of a firm may be fixed in SR because it has purchased or leased a particular plant, but firm can alter size of its plant in LR. ♦E.g., Flo has already built a chicken coop, which restricts her ability to ∆ output level in SR. In LR, Flo can build a new larger coop to produce more. ●Size of a firm may be fixed in SR because it has purchased or leased a particular plant, but firm can alter size of its plant in LR. ♦E.g., Flo has already built a chicken coop, which restricts her ability to ∆ output level in SR. In LR, Flo can build a new larger coop to produce more.

40. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. ●LR AC curve differs from SR AC curve because all inputs are variable in LR. ♦E.g., In SR, Flo can only chose how many chickens to squeeze into coop. In LR, she can chose among different coop sizes. ●LR AC curve differs from SR AC curve because all inputs are variable in LR. ♦E.g., In SR, Flo can only chose how many chickens to squeeze into coop. In LR, she can chose among different coop sizes. Average Cost Curve in the Short and Long Run

41. FIGURE 8. Flo’s SR and LR Average Cost Curves

42. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Average Cost Curve in the Short and Long Run ●If Flo expects to sell 40 → she buys a small coop with AC of SL. If Q = 40 → AC = $12 (pt U). ●She is surprised by strong D and can sell 100 with AC = $12 (pt V). ●Now she needs a bigger coop with AC of BG with its lower AC of $9 for Q = 100. ●In SR, Flo is stuck with AC of SL. In LR, she can replace coop and the relevant AC is STG. ●LR AC curve shows the lowest possible SR AC for each output level. ●If Flo expects to sell 40 → she buys a small coop with AC of SL. If Q = 40 → AC = $12 (pt U). ●She is surprised by strong D and can sell 100 with AC = $12 (pt V). ●Now she needs a bigger coop with AC of BG with its lower AC of $9 for Q = 100. ●In SR, Flo is stuck with AC of SL. In LR, she can replace coop and the relevant AC is STG. ●LR AC curve shows the lowest possible SR AC for each output level.

43. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Economies of Scale ●Returns to scale indicates how the output level changes when all the firm's inputs are doubled. 1.Increasing Returns to Scale (IRTS): Q output more than doubles. ●IRTS gives a cost advantage to larger firms. Found in industries like telecommunications, electricity, automobiles, and aircraft. 2.Constant Returns to Scale (CRTS): Q output doubles. 3.Decreasing Returns to Scale (DRTS): Q output less than doubles. ●Gives a cost advantage to smaller firms. Most U.S. industries have DRTS. ●Returns to scale indicates how the output level changes when all the firm's inputs are doubled. 1.Increasing Returns to Scale (IRTS): Q output more than doubles. ●IRTS gives a cost advantage to larger firms. Found in industries like telecommunications, electricity, automobiles, and aircraft. 2.Constant Returns to Scale (CRTS): Q output doubles. 3.Decreasing Returns to Scale (DRTS): Q output less than doubles. ●Gives a cost advantage to smaller firms. Most U.S. industries have DRTS.

44. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Economies of Scale ●Returns to scale impacts the shape of the AC curve. ●AC = TC/Q output = (P input x Q input)/Q output ♦E.g., if Q inputs doubles and Q output doubles, then AC is constant. ●Returns to scale impacts the shape of the AC curve. ●AC = TC/Q output = (P input x Q input)/Q output ♦E.g., if Q inputs doubles and Q output doubles, then AC is constant.

45. FIGURE 9. 3 Possible Shapes for the AC Curve Long-Run Average Cost (c) Quantity of Output Decreasing returns to scale Long-Run Average Cost (b) Quantity of Output Constant returns to scale Long-Run Average Cost (a) Quantity of Output Increasing returns to scale AC

46. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Economies of Scale ●Law of dim. marginal returns and IRTS may seem contradictory, but they are unrelated. ●Dim. marginal returns refers to increasing a single input. Returns to scale refers to a doubling of all inputs. ●A firm with dim. returns to a single input could have IRTS, CRTS, or DRTS. ●Law of dim. marginal returns and IRTS may seem contradictory, but they are unrelated. ●Dim. marginal returns refers to increasing a single input. Returns to scale refers to a doubling of all inputs. ●A firm with dim. returns to a single input could have IRTS, CRTS, or DRTS.

47. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Price and Quantity: One Decision, Not Two ●Critical decision -when Apple decides how many ipods to produce and P it will charge. ●P affects how consumers respond and Q affects K and L costs. ●When firms chose P and Q to max profits → they can pick only one –P or Q. ♦Chose P → customers decide Q ♦Chose Q → market determines P at which this Q can be sold ●Critical decision -when Apple decides how many ipods to produce and P it will charge. ●P affects how consumers respond and Q affects K and L costs. ●When firms chose P and Q to max profits → they can pick only one –P or Q. ♦Chose P → customers decide Q ♦Chose Q → market determines P at which this Q can be sold

48. FIGURE 10. Demand Curve for Flo’s Poultry Meat D Quantity of Chicken (20 lb-packages per week) Price per package A 1 $19 B 9 $11 Flo faces a local D curve. If she picks P = $19 → Qd = 1. If she picks Q = 9 → P = $11 to find required # of customers.

49. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Price and Quantity: One Decision, Not Two ●Each pt on D curve corresponds to a (P,Q) pair. A firm can pick 1 pair, but it can never pick P from 1 pt on D and a different Q from another pt on D. ●Economists assume that firms pick (P,Q) pair that maximizes profits. ●Each pt on D curve corresponds to a (P,Q) pair. A firm can pick 1 pair, but it can never pick P from 1 pt on D and a different Q from another pt on D. ●Economists assume that firms pick (P,Q) pair that maximizes profits.

50. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Total Profit: Keep Your Eye on the Goal ●Total profit (or economic profit) = TR – TC (including opportunity cost) ♦Opportunity costs include any K or L supplied by the firm’s owners. ●Economic profit = Accounting profit – opportunity cost. ♦E.g., if a talented attorney, gives up her salary of $120,000 to start her own law firm and earns $150,000 after paying for all operating costs → accounting profit = $150,000 but economic profit = $30,000 ♦E.g., if you start a business and earn 6% on money you invested but could have earned 4% in T-Bills → economic profit = 2%. ●Total profit (or economic profit) = TR – TC (including opportunity cost) ♦Opportunity costs include any K or L supplied by the firm’s owners. ●Economic profit = Accounting profit – opportunity cost. ♦E.g., if a talented attorney, gives up her salary of $120,000 to start her own law firm and earns $150,000 after paying for all operating costs → accounting profit = $150,000 but economic profit = $30,000 ♦E.g., if you start a business and earn 6% on money you invested but could have earned 4% in T-Bills → economic profit = 2%.

51. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Total Profit: Keep Your Eye on the Goal ●Total, Average, and Marginal Revenue: ♦Total Revenue (TR) = P  Q ■Calculated from D curve ♦Average Revenue (AR) = TR/Q = (P  Q)/Q = P ■AR curve = D curve ♦Marginal Revenue (MR) =  TR when ↑output by 1 unit. ■Slope of TR curve ●Total, Average, and Marginal Revenue: ♦Total Revenue (TR) = P  Q ■Calculated from D curve ♦Average Revenue (AR) = TR/Q = (P  Q)/Q = P ■AR curve = D curve ♦Marginal Revenue (MR) =  TR when ↑output by 1 unit. ■Slope of TR curve

52. TABLE 5. Schedule of Flo’s Total, Average, and Marginal Revenue Chicken (20 lb-pack) Price (or AR) ($ per package) Total Revenue (P x Q) Marginal Revenue 0-----0 1$19 2183617 3 5115 4166413 5157511 614849 713917 812965 911993 10 1001

53. FIGURE 11. Flo’s Total Revenue Curve

54. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Total Profit: Keep Your Eye on the Goal ●Total, Average, and Marginal Cost: ♦TC = P inputs x Q inputs ♦AC = TC/Q output ■Per unit costs ♦MC = ∆TC when ↑output by 1 unit. ■Slope of TC curve ●Total, Average, and Marginal Cost: ♦TC = P inputs x Q inputs ♦AC = TC/Q output ■Per unit costs ♦MC = ∆TC when ↑output by 1 unit. ■Slope of TC curve

55. TABLE 6. Flo’s Total, Average, and Marginal Cost Chicken (20 lb-pack) Total CostMarginal CostAverage Cost 0$0.0----- 117.0$17.0 226.09.013.0 333.07.011.0 440.07.010.0 548.08.09.6 657.09.09.5 767.210.29.6 880.012.810.0 999.019.011.0 10125.026.012.5

56. FIGURE 12(a). Flo’s Total Cost Curve

57. FIGURE 12(b). Flo’s Average and Marginal Cost Curves

58. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Total Profit: Keep Your Eye on the Goal ●Maximization of Total Profits: ♦Profits typically increase with output, then fall. ♦Some intermediate level of output generates max profit. ●Maximization of Total Profits: ♦Profits typically increase with output, then fall. ♦Some intermediate level of output generates max profit.

59. TABLE 7. TR, TC, and Profit for Flo Chicken (20 lb-pack) Total Revenue (P x Q) Total CostTotal Profit 0$0$0.0 11917.02.0 23626.010.0 35133.018.0 46440.024.0 57548.027.0 68457.027.0 79167.223.8 89680.016.0 99999.00.0 10100125.0-25.0

60. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Total Profit: Keep Your Eye on the Goal ●In our example: ♦Total profit (Π) is max at 5 or 6 packages, where farm earns its highest profits of $27 per week. ♦Any other Q level → ↓Π ■E.g., if Q = 3 → Π = $18 or if Q = 8 → Π = $16 ●In our example: ♦Total profit (Π) is max at 5 or 6 packages, where farm earns its highest profits of $27 per week. ♦Any other Q level → ↓Π ■E.g., if Q = 3 → Π = $18 or if Q = 8 → Π = $16

61. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Marginal Analysis and Maximization of Total Profit ●Use marginal analysis to find Q that max profits. ●Marginal profit = ∆ total profit when ↑Q by 1 unit. ♦Slope of total profit curve ●Rule: if marginal Π > 0 → ↑Q if marginal Π < 0 → ↓Q ♦Profit-max Q is reached when marginal Π = 0. ●Graphically, only reach top of total profit “hill” when marginal profit (its slope) = 0. ●Use marginal analysis to find Q that max profits. ●Marginal profit = ∆ total profit when ↑Q by 1 unit. ♦Slope of total profit curve ●Rule: if marginal Π > 0 → ↑Q if marginal Π < 0 → ↓Q ♦Profit-max Q is reached when marginal Π = 0. ●Graphically, only reach top of total profit “hill” when marginal profit (its slope) = 0.

62. FIGURE 13(a). Profit Maximization 5 Output, Packages per week 109876432 1 –30 –20 0 20 27 Total Profit per week ($) Total Profit “hill” Total profit has a “hill” shape. At Q = 0, Π = 0. At larger Q levels, firm floods the market, and ↓ Π. Only at intermediate Q levels is Π > 0.

63. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Marginal Analysis and Maximization of Total Profit ●Like marginal Π, MR and MC can guide us to Q output where total profit is maximized. ●MR = slope of TR and MC = slope of TC ●Total profit is max when TR and TC are farthest apart. ♦Occurs when their slopes are equal, so they are not growing closer together (Π↓) or growing further apart (Π↑). ●Rule: if MR > MC →  Q if MR < MC →  Q ♦Profit maximizing Q is where MR = MC. ●Like marginal Π, MR and MC can guide us to Q output where total profit is maximized. ●MR = slope of TR and MC = slope of TC ●Total profit is max when TR and TC are farthest apart. ♦Occurs when their slopes are equal, so they are not growing closer together (Π↓) or growing further apart (Π↑). ●Rule: if MR > MC →  Q if MR < MC →  Q ♦Profit maximizing Q is where MR = MC.

64. FIGURE 13(b). Profit Maximization TC TR Profit Output, packages per week 5 Total Revenue, Total Cost per week ($) 10987643210 99 84 57 20 $27 125 Total Π = vertical distance between TR and TC curves

65. TABLE 8. Maximization of Flo’s Total Profits Output (packages) Marginal Revenue Marginal Cost Marginal Profit Total Profit 0----- $0.0 1$19$17.0$2.02.0 2179.08.010.0 3157.08.018.0 4137.06.024.0 5118.03.027.0 699.00.027.0 7710.2-3.223.8 8512.8-7.816.0 9319.0-16.00.0 10126.0-25.0

66. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Marginal Analysis and Maximization of Total Profit ●Finding the Optimal P from Optimal Q: ●Optimal Q is where MR = MC (and marg. Π = 0 ). ♦E.g., at Q = 6; MR = MC = $9. ●Producer picks Q then demand curve  P buyers will pay to purchase that level of output. ♦E.g., at Q = 6 → P = $14 –only P at which this Q is purchased by consumers. ●Finding the Optimal P from Optimal Q: ●Optimal Q is where MR = MC (and marg. Π = 0 ). ♦E.g., at Q = 6; MR = MC = $9. ●Producer picks Q then demand curve  P buyers will pay to purchase that level of output. ♦E.g., at Q = 6 → P = $14 –only P at which this Q is purchased by consumers.

67. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Logic of Marginal Analysis & Maximization ●Decision makers constantly faced with problem of choosing the magnitude of some variable. ♦E.g., how many cars to produce; how many workers to hire, or how many pints of ice cream to buy. ●Generally, larger the number selected → higher the total benefit. However, costs ↑ as number chosen ↑. ●Optimally, decision makers chose Q of some variable where difference between total benefit and total cost is greatest. ●Decision makers constantly faced with problem of choosing the magnitude of some variable. ♦E.g., how many cars to produce; how many workers to hire, or how many pints of ice cream to buy. ●Generally, larger the number selected → higher the total benefit. However, costs ↑ as number chosen ↑. ●Optimally, decision makers chose Q of some variable where difference between total benefit and total cost is greatest.

68. Logic of Marginal Analysis & Maximization ●Decide about Q of some variable, then max net benefit = total benefit – total cost by choosing the Q where marginal benefit = marginal cost. ●Rule is true regardless of who the decision maker is. ●Decide about Q of some variable, then max net benefit = total benefit – total cost by choosing the Q where marginal benefit = marginal cost. ●Rule is true regardless of who the decision maker is. Decision maker Marginal benefit Marginal cost Choice variable Objective consumerMUP goodQ of goodMax CS firmMRP inputP inputQ of 1 inputMax Π firmMR outputMC outputQ of outputMax Π